NQ Mobile has been under pressure since Muddy Waters accused the company of various wrongdoings. The fight has lasted several months with no victor in sight. NQ Mobile recently reported earnings, which disappointed investors, and investors sent shares down 20%. On the conference call NQ Mobile Inc (ADR) (NYSE:NQ) indirectly discussed the battle with Muddy Waters without mentioning the firm by name. Muddy Waters just released a new report on NQ which can be found below:
Muddy Waters, LLC
NQ Mobile: You Can’t Fool All of the People All of the Time
April 13, 2014
PwC’s Additional Scrutiny Ensured NQ Reported a
Q4 Loss and Negative Operating Cash Flow
Based on NQ’s disappointing Q4 results, including its surprising GAAP loss and negative operating cash flow, we strongly believe that NQ’s auditor, PriceWaterhouseCoopers Zhongtian (“PwC Zhongtian”), bolstered its level of due diligence during its 2013 audit of the company. Our view is supported by the fact that NQ took an extra month to release its Q4 earnings compared to last year.
NQ surprised investors by reporting a reduction in gross margin and negative operating cash flow in its Q4 results. This indicates to us that PwC was doing its job in a more robust manner than in prior years, although we expect NQ to receive an unqualified audit opinion before the end of the month. As long as NQ has excuses for cash not flowing into its accounts (i.e., its negative operating cash flow), it can essentially report whatever revenue amount it wants. We saw these same shenanigans in our investigation of Sino-Forest, which was subsequently confirmed during the company’s bankruptcy proceedings. Sino-Forest’s bankruptcy monitor reported that over 95% of its reported gross profit never actually showed up in its bank accounts. Sino-Forest’s auditor was aware of this, but, like NQ, Sino-Forest was able to tell its auditor that it used the cash in its operations. Without needing to show cash in its bank accounts, there was nothing to stop Sino-Forest from overstating revenue and assets by billions of dollars.
In its Q4 results, NQ’s uses a massive increase in prepayments to vendors and a big pay down in accounts payable as an excuse for not showing an increase in cash. As always, NQ’s accounts receivable Days Sales Outstanding remained implausibly high. Had we released our initial report during NQ’s audit (i.e., after December 31st), we believe that NQ would not have had time to adequately prepare its defenses and excuses against a more robust audit.
To understand why NQ’s results were much worse than expected, investors need to realize that prior audits of the company were likely not as rigorous, and the extra scrutiny made it harder to fake profits and cash flow in Q4.
As we have said multiple times before, audits of public companies are not designed to detect fraud. Auditing standards presume that company documents are genuine and management does not make misrepresentations about their numbers. Audits are generally performed from pre-constructed checklists that are used in thousands of public company audits throughout the world.
These checklists incorporate the standard presumption of honesty. As a result, auditors are not visiting a company’s customers to make sure revenue is accurate nor are they visiting suppliers to confirm whether the company’s volumes match up with the financials they are reporting.
Auditors also do not review government files to confirm that a company’s filings with the government are the same as what they report on their financial statements.
Auditors don’t view themselves as fraud detectors, which is why an audit has been one of the least likely ways to uncover wrongdoing.
Instead, auditors follow their checklists. These can be made somewhat more robust when there are potential fraud concerns; but even so, the only anti-fraud measure in an auditor’s checklist is the cash confirmation procedure. Unfortunately, investors are never told whether an auditor confirmed cash merely by looking at the static balance as of December 31st, or whether it checked the balance on other dates and reviewed inflow and outflow transactions.
NQ Mobile Continued its Pattern of Overpaying for Acquisitions in Order to Roundtrip Revenue
NQ announced that it yet again spent a lot of money on what is likely a little company called Tianjin HuaYong Wireless Technology Ltd. (vLife). (vLife had only raised a total of $500,000 since inception in 2006, and appears to have previously operated a dating website.) NQ announced that it bought 58% of this company for approximately $80 million. Most of the acquisition consideration was in shares and U.S. dollars. NQ’s acquisition pattern is atypical for U.S.-listed Chinese companies (and frauds) in that it pays for much of its acquisitions in shares. This is especially strange considering that NQ has said it is preserving cash raised through its IPO and other share offerings. We believe the real reason NQ relies so heavily on share issuances is that it reports a significant level of fraudulent revenue from outside of China. (Note that it seems very little of NQ’s non-China revenue comes from the U.S. or other developed markets.) Because of China’s capital controls, NQ needs to have offshore cash in order to fake its non-China revenue. It is highly likely that much of the monetized stock issued for the acquisition will be recorded on the books as international “revenue” in the future.
NQ’s Revenue Growth is a Desperate Attempt to Keep a Floor under the Stock Price
NQ’s larger than expected revenue growth and increased guidance are the only tools it has as it attempts to keep its stock price up. However, NQ had to do some back flips in order to report this inflated revenue, including reporting a mix of revenue that was not in accordance with its previous guidance. In Q4 2013, advertising revenue was much larger than NQ had led investors to expect.
Some types of revenue are easier to fake than others. Our observation is that advertising revenue-based frauds in China are among the easiest to commit. Legitimate operators in the advertising industry deal with numerous intermediaries, and pricing structures are among the most opaque of any industry. For a fraudster, it’s easy pickings. In NQ’s case, its advertising revenue comes from almost impossible to verify channels such as “third party application referrals through our mobile security products, mobile game and our advertising network platform”.1
If just one year ago, an investor predicted that NQ would generate any advertising revenue in 2013 – let alone $16.7 million in Q4 – they would have been easily dismissed. NQ founder and chairman Yu Lin even made this statement in January 2013:
“Why don’t we take ads? I think the format of ads on mobile phones is not mature yet. Furthermore, there is a fundamental conflict between our safety service, by its very nature, and the advertising model. If you want to target ads accurately, there will be privacy issues.”2
Co-CEO Omar Khan indicated that Q1 2014 results will also be heavily reliant on advertising revenue. If NQ reports strong Q1 2014